Model Answer
0 min readIntroduction
The New Classical Theory, emerging in the 1970s as a challenge to Keynesian economics, posits that markets are continuously clearing and that individuals possess rational expectations. This fundamentally alters the understanding of macroeconomic fluctuations and, crucially, the shape of the aggregate demand (AD) curve. Unlike the Keynesian view of a downward-sloping AD curve, the New Classical model predicts a vertical AD curve. This is because changes in the money supply, the primary driver of AD in this framework, only affect nominal variables like price levels and have no real impact on output. Understanding how this vertical AD curve is derived is central to grasping the New Classical perspective on macroeconomic policy.
Core Principles of the New Classical Theory
The derivation of the real aggregate demand curve in the New Classical framework rests on several key assumptions:
- Rational Expectations: Individuals form expectations about the future based on all available information, including government policies. They do not make systematic errors.
- Market Clearing: Prices and wages are perfectly flexible and adjust instantaneously to equate supply and demand in all markets. There is no involuntary unemployment.
- Classical Dichotomy: Real variables (output, employment, real interest rates) are determined by real factors (technology, preferences), while nominal variables (price level, nominal interest rates) are determined by monetary factors.
- Neutrality of Money: Changes in the money supply only affect nominal variables and have no lasting effect on real variables.
Deriving the Aggregate Demand Curve
The New Classical AD curve is derived from the aggregate supply and aggregate demand interaction, but with a crucial difference in how AD is conceptualized. Let's break down the process:
1. The Aggregate Supply (AS) Curve
In the New Classical model, the long-run aggregate supply curve is vertical at the economy’s potential output level (Y*). This is because, in the long run, wages and prices are fully flexible, and the economy operates at its natural rate of unemployment. Any attempt to increase output beyond Y* through monetary policy will only lead to inflation.
2. The Role of Money Supply
The New Classical model views changes in the money supply (M) as the primary driver of aggregate demand. However, due to rational expectations, individuals anticipate the inflationary consequences of an increase in M. They adjust their nominal wages and prices accordingly.
3. The Impact on Nominal vs. Real Variables
When the money supply increases, nominal wages and prices rise proportionally. This means that real wages (nominal wages/price level) remain unchanged. Since real wages are unchanged, the level of output (Y) also remains unchanged at its potential level (Y*). The increase in the money supply only leads to a proportional increase in the price level (P).
4. The Vertical Aggregate Demand Curve
Because changes in the money supply only affect the price level and not output, the aggregate demand curve is vertical at Y*. This implies that any increase in the money supply will simply lead to a higher price level, without any change in the quantity of goods and services demanded. Mathematically, this can be represented as:
AD: Y = Y*
This contrasts sharply with the Keynesian AD curve, which slopes downward due to sticky prices and wages, and the belief that increases in AD can boost output in the short run.
Implications for Policy
The vertical AD curve has significant implications for macroeconomic policy. According to the New Classical model, discretionary monetary and fiscal policies are ineffective in influencing real output. Any attempt to stimulate the economy will only lead to inflation, as individuals anticipate the policy changes and adjust their behavior accordingly. This is often referred to as the “policy ineffectiveness proposition.”
Real Business Cycle Theory
A related concept, Real Business Cycle (RBC) theory, further emphasizes the role of real shocks (e.g., technological changes, changes in preferences) as the primary drivers of economic fluctuations. These shocks affect the potential output level (Y*), shifting the vertical AS and AD curves simultaneously.
Conclusion
In conclusion, the New Classical Theory derives a vertical aggregate demand curve based on the assumptions of rational expectations, market clearing, and the neutrality of money. This implies that monetary policy is ineffective in influencing real output and that economic fluctuations are primarily driven by real shocks. While the New Classical model has been criticized for its unrealistic assumptions, it provides a valuable alternative perspective on macroeconomic dynamics and highlights the importance of expectations and market flexibility. It serves as a crucial benchmark for understanding the limitations of traditional Keynesian policies.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.